ANNEX I: Effective Average Tax Rates Based on Macroeconomic Data
188. Mendoza, Razin, and Tesar compute effective average tax rates using national accounts and actual tax revenue data.60 61 These effective tax rates are consistent with the tax rates faced by a representative agent in a general equilibrium setup. The numerators measure the difference between the before-tax and after-tax values of consumption, labor income, and capital income, approximated by the tax revenue collected from each tax. The tax bases in the denomerators measure consumption, labor income, and capital income at before-tax prices.
ANNEX II: Marginal Effective Tax Rates on Investment
193. The calculations of marginal effective tax rates on investment closely followed accepted methodology.62 Corporate and personal income taxes drive a wedge between the before-corporate tax rate of return, p, on an investment project and the after-tax return, s, that an individual investor receives. Consider an investment project with a depreciation rate of δ and a perpetual rate of return, r. The before-tax net rate of return is therefore p=r-δ. Denote the present value of depreciation allowances and other tax incentives by A. For a marginal investment project, in equilibrium the net cost of the project (1-A) is equal to the present value of the discounted future after-tax cash flow,
where τ is the corporate income tax rate, ρ is the discount factor, and π is the rate of inflation. Solving for the before-tax rate of return, p, yields
194. Suppose an investor can earn a nominal interest rate, i, on an alternative investment, subject to a personal income tax rate, m. Then the real after-tax return, s, on the alternative investment is
195. The marginal effective tax rate, t, on income from the investment project is defined as the ratio of the tax wedge (between the before-tax return on the investment, p, and the after-tax return for the investor, s) and the before-tax return, p,
196. In the absence of any taxes (and assuming investors are risk neutral), the factor used to discount the project’s cash flow would be equal to the rate of return in the capital market, i. However, if corporate and personal income taxation differentiates between interest payments, capital gains, and distributed profits, the effective discount rate depends on how the investment project is financed. For debt financing, the appropriate discount rate is ρ=(1 - τ)i, because interest payments are tax deductible for the corporation. For new equity issues, the discount rate is ρ = i/0, where θ captures the different tax rates on retained earnings and distributed profits. In the German case, with full imputation θ = 1/(1 - τ), and thus ρ = (1 - τ)i. For retained earnings, the discount rate is ρ = (1 - m)i.
Prepared by Burkhard Drees and Wolfgang Merz.
Including the solidarity surcharge on income tax, which would be cut by 2 percentage points, the top income tax rate would drop from 57 percent to 41 percent.
The opposition SPD’s income tax reform plan, which was released in May 1997, envisaged tax relief of Vi percent of GDP. It would fully offset an increase in the basic personal income tax allowance, a lower entry rate on personal income (with the top marginal tax rate kept unchanged), and a reduced tax rate on retained corporate earnings by broadening the corporate tax base and by a hew wealth tax on personal assets. The SPD has also proposed to lower social security contributions by 2 percentage points (equivalent to ¾ percent of GDP) financed by higher VAT and mineral oil taxes (½ percent of GDP). An increase in child benefits would be financed by a special program to combat tax evasion.
For an analysis of the 1998 U.S. tax reform, see A. J. Auerbach and J. Slemrod, “The Economic Effects of the Tax Reform Act of 1986”, Journal of Economic Literature, XXXV (June 1997), pp. 589-632.
The narrowing of the tax base has been in part due to tax incentives designed to benefit the new Länder. Reform of these tax measures was not within the terms of reference of the Waigel Commission. The Government intends to replace numerous special depreciation allowances by direct investment grants from 1998 onward.
For an outline of the reforms; see L. Lipschitz, J. Kremers, T. Mayer, and D. McDonald, The Federal Republic of Germany: Adjustment in a Surplus Country, IMF Occasional Paper No. 64, January 1989 (Washington: International Monetary Fund).
Since 1995, a solidarity surcharge of 7.5 percent of the income tax liability has been imposed.
In the 1997 Tax Act, the maximum deduction from taxable income for expenses in connection with employment of domestic help was raised from DM 12,000 to DM 18,000.
As an example, heavily debt-financed real estate investments may record tax losses, which can be deducted from taxable income, due to their financing costs and an annual depreciation allowance of 5 percent during the first seven years. In addition, if the property is later sold, the capital gains are tax-exempt.
Horizontal fairness treats taxpayers with similar incomes in a comparable way, while vertical fairness treats taxpayers according to their ability to pay.
Losses of up to DM 10 million can be carried backward a maximum of two years. A huge overhang of potential corporate loss carry-overs exists—official estimates were more than DM 200 billion in 1997—that can be used at any time to reduce tax liabilities.
O. Lang, K.-H. Nöhrbass, and K. Stahl, “On Income Tax Avoidance: The Case of Germany”, ZEW Discussion Paper No. 93-05, March 1993 (Mannheim: Zentrum fur Europäische Wirtschaftsforschung). This study was based on the 1983 German Income and Consumption Survey.
See Council of Economic Experts, Im Standortwettbewerb, Annual Report 1995 (Stuttgart: Sachverständigenrat), p. 203.
Lang et al., “On Income Tax Avoidance”.
The 20 largest listed companies in Germany have reduced their effective tax rate by 11 percentage points since 1991, partly by shifting the taxation of profits abroad; see German Brief, 5/2/97, published by the Frankfurter Allgemeine Zeitung GmbH Information Services.
In Chart IV-4, the data on statutory tax rates are from Price Waterhouse, “Individual Taxes: A Worldwide Summary,” (New York, 8/1996), and Deloitte Touche, “Taxation in Western Europe,” (New York, October 1996).
In Chart IV-5, data on statutory tax rates are from Price Waterhouse, “Corporate Taxes: A Worldwide Summary,” (New York, 8/1996), and Deloitte Touche, “Corporate and Withholding Tax Rates Between Major Trading Nations,” (New York, April 1995).
E. G. Mendoza, A. Razin, and L. L. Tesar, “Effective Tax Rates in Macroeconomics: Cross-country Estimates of Tax Rates on Factor Incomes and Consumption,” Journal of Monetary Economics, Vol. 34, 1994, pp. 297-323.
D. D. Lassen and S. B. Nielsen, “Is the Tax Burden in Denmark Higher than in Other European Countries?” Nationaløeconomisk Tidsskrift, Vol. 134, 1996, pp. 209-222.
T. Tyrväinen, “Wage Determination in the Long Run, Real Wage Resistance and Unemployment: Multivariate Analysis of Cointegrating Relations in 10 OECD Countries,” Discussion Paper, December 1995 (Helsinki: Bank of Finland).
W. Leibfritz, J. Thornton, and A. Bibbee, “Taxation and Economic Performance,” Economics Department Working Paper No. 176, (Paris: OECD), 1997, and F. Daveri and G. Tabellini, “Unemployment, Growth and Taxation in Industrial Countries,” unpublished, 1997.
M. A. King and D. Fullerton, eds., The Taxation of Income from Capital: A Comparative Study of the United States, United Kingdom, Sweden, and West Germany (Chicago: University of Chicago Press, 1984).
D.W. Jorgenson and R. Landau, eds., Tax Reform and the Cost of Capital: An International Comparison, (Washington: The Brookings Institution, 1993).
A similar picture emerges based on corporate tax rates alone.
W. Leibfritz, “Germany” in Tax Reform and the Cost of Capital: An International Comparison, ed. by Dale W. Jorgenson and Ralph Landau, (Washington: The Brookings Institution), 1993.
These results could be considered a paradox since more than three-quarters of investment in Germany is typically financed by internally generated funds (J.S.S. Edwards and K. Fischer, “Banks, Finance, and Investment in West Germany since 1970”, Discussion Paper No. 497, ed. by Center for Economic Policy Research, (London), January 1991). However, the methodology used to estimate effective marginal tax rates does not incorporate the effects of accounting rules (except depreciation allowances). German accounting rules afford relatively wide discretion in valuing assets and are geared toward the protection of creditors. As a result, profits tend to be understated and sizable hidden reserves are routinely built up in corporate balance sheets. The implied tax saving effects for internal financing that stem from hidden reserves are not included in the calculations of effective marginal tax rates.
Press Office of the Federal Government, “Steuerreform”, Aktuelle Beiträge zur Wirtschaftsund Finanzpolitik, No. 13/1997, 6/26/1997.
Individuals can claim a saver’s tax-free allowances of currently DM 6,000 for a single tax payer; this allowance is proposed to be halved in 1999.
C. Thimann, “Effective Taxation for Recipients of Social Assistance in Germany and the Consequences of the 1996 Tax Reform”, IMF Working Paper 95/120, November 1995 (Washington: International Monetary Fund).
The Commission on Alternative Tax-Transfer Systems recommended, inter alia, that the income calculations that determine social benefits be aligned with the income calculations for income taxation purposes, and that the share of wage income that counts toward social assistance benefits be reduced; Commission on Alternative Tax-Transfer Systems, “Integration of Income Taxation with Tax Financed Social Benefits”, Schriftenreihe, Heft 59, ed. by Ministry of Finance (Bonn), June 1996.
The Government had proposed some measures to broaden the tax base which subsequently were changed during the deliberations in the Bundestag. For example, the Government proposed to subject bonus pay for work on Sundays, Holidays and at night to full taxation starting in 1999, whereas the Bundestag opted to phase out these exemptions over four years. In addition, the Bundestag eliminated the proposal to tax half of unemployment benefits, short-time work compensation and bad weather pay, which are presently completely exempt.
Currently only that part of public pensions that represents a (fictitious) return on investment (Ertragsanteil) (about 27 percent on average) is taxed. The taxable income share of 50 percent was apparently chosen since tax-exempt employer-paid pension contributions constitute half of the total pension contributions.
This proposal was accepted by both the Bundestag and Bundesrat in July. Municipalities would be compensated for the revenue foregone by receiving a larger share of VAT revenues.
Bareis Commission, “Report of the Income Tax Commission on the Tax Exemption of Subsistence Income and on Income Tax Reform”, Schriftenreihe, Heft 55, ed. by Ministry of Finance (Bonn), August 1995.
Mr. Uldall advocated in January 1995, a personal income tax code with a top marginal tax rate of 28 percent on personal and corporate income. The revenue loss of DM 120 billion would be financed partially by eliminating nearly all tax breaks (about DM 80 billion). G. Uldall, Proposal for a Reform of Income and Corporate Taxation, (Bonn), January 1995.
Some experts consider a tax on capital gains on stocks a double taxation of retained earnings.
The reduction in corporation tax rates in 1998 would be broadly revenue-neutral due to a planned reduction in some depreciation allowances in the corporate sector (see table).
Ministry of Finance, Finanzielle Auswirkungen der Steuerreform 1998/1999, June 1997.
See DIW, “Tax Reform 1998/99: No Success in Tackling Unemployment”, Wochenbericht 15/97 (Berlin: Deutsches Institut für Wirtschaftsforschung) April 1997.
According to DIW, the effective tax burden on enterprises declined from 37 percent in 1980 to 22 percent in 1997. The tax burden was measured by the ratio of the assessed income tax, the relevant part of the solidarity surcharge, withholding tax on interest income, corporate income tax, the wealth tax, and the local trading tax relative to gross entrepreneurial and property income.
For example, single tax payers without children and gross incomes of DM 30,000 would benefit from a 27.7 percent reduction in their tax liability; at a salary of DM 100,000 the tax cut would amount to 11.7 percent before rising again and reaching 25 percent for higher incomes. At an annual income of DM 200,000, taxes would be cut by 20 percent.
OECD, Taxing Profits in a Global Economy: Domestic and International Issues, (Paris: OECD), 1991.
The approach applied in OECD (1991) is based on the King and Fullerton (1984) methodology. But in contrast to the above mentioned analysis in Jorgenson and Landau (1993), which employs the “constant p approach” (fixing the pre-tax required rate of return of investment projects), following the OECD (1991) the “constant r approach” is utilized in this study. In the “constant r approach”, the return on alternative investments (before personal income tax) is used to anchor the calculations. The calculated effective tax rates on investment should, however, be interpreted as merely illustrative since they cannot capture all relevant features of the tax system.
ZEW (Zentrum fur Europäische Wirtschaftsforschung), “Testimony in the Bundestag Finance Committee Hearing on Tax Reform”, May 14-16, 1997.
This calculation includes the reduction in the corporate tax rate, the solidarity surcharge and local trading tax on capital, and new depreciation rules. The new accounting rules, such as the write-up requirement, are not taken into account.
DIW, Tax Reform 1998/99.
RWI, “Testimony in the Bundestag Finance Committee Hearing on Tax Reform”, May 14-16, 1997.
See Leibfritz et al, (1997), “Taxation and Economic Performance.”
For these calculations, the total income tax relief of the proposed reform (1.1 percent of GDP) is assumed to be almost evenly split between relief on wage taxes and other (i.e. profit taxes) (Table IV-4); in addition, consumption taxes (VAT) would be raised by ½ percent of GDP.
Daveri and Tabellini (1997) show how endogenous growth features in an economy (such as a production externality where firms are more productive the larger the per-capita capital stock in the economy is) can create positive effects from tax reform on the real GDP growth rate.
For a review of the effects on the housing sector, see M. Kelle and R. May, “The Effects of the Tax Reform on the Housing Sector”, Bundesbaublatt, May 1997.
In 1996, an estimated two-thirds of all rental units financed at market rates were financed by private investors; M. Kelle and R. May, “The Effects of the Tax Reform on the Housing Sector”, Bundesbaublatt, May 1997.
See Deutsches Institut für Wirtschaftsforschung (DIW); Institut für Weltwirtschaft (IfW); and Institut für Wirtschaftsforschung Halle (IWH); Micro- and Macroeconomic Adjustment Processes in East Germany—Fifteenth Report,” 1997.
American Chamber of Commerce in Germany, “Testimony in the Bundestag Finance Committee Hearing on Tax Reform”, May 14-16, 1997.
See e.g. H. Kaiser, U. van Essen, and P. B. Spahn, “Income Taxation and the Supply of Labor in West Germany: a Microeconometric Analysis with Special Reference to the West German Income Tax Reforms, 1986-1990”, in Empirical Approaches to Fiscal Policy Modeling, ed. by Alberto Yeimler and Daniele Meulders, (London), 1993.
Mendoza, Razin, and Tesar, “Effective Tax Rates”.
The calculations are based on data from the OECD Revenue Statistics.
See OECD, Taxing Profits in a Global Economy, and King and Fullerton, The Taxation of Income from Capital.